Discover Financial Beats Earnings on Loan Growth & Buyback

Discover Financial Services (DFS) managed to keep its surprise momentum alive with the second quarter earnings, marking three straight quarters of earnings beat averaging 4.6%. Second-quarter 2014 earnings per share (EPS) of $1.35 exceeded the Zacks Consensus Estimate of $1.30 per share and improved 13% from the year-ago quarter.

The stellar results were primarily due to loan growth and share repurchases. Discover Financial’s strong performance was also evident from the double-digit new account growth. Moreover, the rollout of a cash back reward card and announcement of new lower rates for students during the quarter contributed positively as well.

Net income allocated to common shareholders increased to $630 million from $588 million in the year-ago quarter.

Discover Financial’s total revenue, net of interest expense, increased 6.4% year over year to $2.2 billion. The improvement came on the back of loan growth and higher net interest margin. Net interest income also improved 11% to $1.59 billion, reflecting loan growth, higher loan yield and a decline in interest expense.

While total other income for Discover Financial suffered a 4.6% decline from the prior-year quarter to $583 million, total other expenses decreased 2.8% to $797 million. The decline in total other income was owing to lower revenues from transaction processing, and protection products, and a decrease in other income. On the other hand, total other expenses decreased due to the absence of a $40 million charge associated with the Diners’s club that was included in the prior-year quarter and a decline in expenses related to marketing and business development.

Segment Update

Direct Banking Segment

Discover Financial’s Direct Banking segment reported pre-tax income of $984 million, reflecting a 2% decline from the year-ago quarter. Revenues, net of interest expense, for the segment increased 7% to $131 million owing to loan growth and higher net interest margin.

Discover Financial’s card sales grew 6% year over year to $29.3 billion, mainly stemming from increased wallet share with the existing customers. Total loans improved 7% to $65.8 billion, aided by a rise of 6% in credit card loans, 5% in private student loans and 26% in personal loans.

Other income decreased 5% year over year, primarily due to a decline in both direct mortgage-related income and protection product revenues. This was partly mitigated by higher interchange revenues. Meanwhile, expenses rose 2% on higher headcount and increased professional fees. This was partly offset by a decline in marketing expense.

Discover Financial’s credit card net charge-off rate declined to 2.33% from 2.34% in the year-ago quarter. Similarly, the over-30 days delinquency rate increased to 1.63% from 1.58%.

In addition, provisions for loan losses increased $135 million year over year to $360 million, reflecting higher loan loss reserves. Reserve build during the quarter was $23 million, lower than $78 million in the year-ago quarter. The decline in reserve build was mainly due to continuous growth in card loan portfolio.

Payment Services Segment

Pre-tax income at Discover Financial’s Payment Services segment was $31 million, comparing favorably with the year-ago loss of $21 million. Revenues in the segment were in line with the year-ago quarter.

Payment Services transaction dollar volume rose 3% from the year-ago quarter to $50.9 billion. Meanwhile, the transaction dollar volume from PULSE increased 4% year over year.

Financial Position

Discover Financial had total assets worth $78.9 billion as of Jun 30, 2014, indicating a rise from $75 billion as of Jun 30, 2013. Total equity was $11.4 billion at the end of Jun 2014, up from $10.4 billion at the end of Jun 2013. Book value per share was $24.46 as on Jun 30, 2014, compared with $21.52 as of Jun 30, 2013.

Discover Financials’s strong performance was also reflected in the 23% return on equity for the second quarter of 2014. Tier 1 common capital ratio at the quarter-end was 15.2%, up 30 bps sequentially on strong earnings.

Share Repurchase Update

During the reported quarter, Discover Financial repurchased 3 million shares worth $177 million, taking the year to date tally to 8.5 million shares for $482 million. This has led to a 1% sequential decline in shares outstanding.

Currently, the company is left with shares worth $3.02 billion under its $3.2 billion share repurchase program authorized in Apr 2014, set to expire in Apr 2016.

To drive shareholders’ value through share repurchases, the company intends to buy back shares worth $1.6 billion, which amounts to half of its total authorization, in the four-quarter period beginning Mar 31, 2014 through Mar 31, 2015.

Dividend Update

On Jul 16, 2014, the board of Discover Financial declared its quarterly cash dividend of 24 cents per share. This dividend is payable on Aug 21, 2014 to shareholders of record as of Aug 7, 2014.

Our Take

Discover Financial successfully surpassed our earnings expectation and improved year over year as well. The Direct Banking segment contributed much, driven by its solid card and loan growth. The company’s commitment to return more value to shareholders has driven the quarterly performance too. We believe that with a strong cash position, Discover Financial will be able to maintain its steady share repurchases and thereby achieve the desired $1.6 million buyback goal.

Moreover the company’s quality services keep it cushioned from significant customer attrition. This is evident from the recent accolades it received. Notably, the International Quality and Productivity Center awarded three Call Center Excellence Awards to Discover Financial for its high-end customer service. Moreover, the implementation of the new core banking platform is viewed favorably by us as it supports all the deposit products and is thus likely to take Discover Financial’s customer service to new heights.

Zacks Rank

Currently, Discover Financial caries a Zacks Rank #2 (Buy). Other stocks in the financial services space worth considering include Capital One Financial Corporation (COF), Credit Acceptance Corp. (CACC) and Encore Capital Group, Inc. (ECPG). All of these have the same Zacks Rank as Discover Financial.